Category: Commodities

The Energy Transition in Emerging Markets. Part 2

 

Assuming current trends, the global annual growth rate of consumption of primary energy will nearly double this coming decade to 1.9%, compared to 1% over the past decade. This is solely because the slow-growing economies of the OECD, with high levels of per capita energy consumption but stagnant or declining growth in demand, are being supplanted by higher-growing emerging economies with very low per capita consumption levels.

A similar scenario can be painted for the growth of oil liquids oil and gas consumption. Since 2013, the emerging world, led by China and India, has consumed more oil and gas than the OECD countries. As shown in the chart below based on data from the Energy Institute Statistical Review, in 2022, non-OECD economies consumed 53% of global oil and gas production. Based on current trends,  this will reach nearly 60% over the next decade. Total demand for oil liquids can be expected to grow by 12 million barrels/day over the next decade to 112.5 million b/d. All of this increase will come from non-OECD economies, led by India, China, and Africa.

 

The transition to new forms of energy has always been slow and arduous, with the innovative fuel taking share by capturing marginal demand increases. We can see this in the chart below from Our World In Data. In all these transitions, the early adopters were the richest countries. Important transition fuels like hydropower and nuclear have stagnated because of high costs of adoption and political barriers. The same is happening today with coal and oil demand continuing to rise in developing countries where renewables are a costly alternative compared to coal and oil.

The scenario for coal consumption is worrisome, if CO2 emissions are the concern. Non-OECD countries already represent 82% of coal consumption. For leading consumers, China, India, and Indonesia, coal is by far the most abundant and cheapest fuel for generating electricity, and annual consumption is expected to continue growing at the trend of the past decade, 0.9%, 4%, and 9%, respectively.

The transition to green fuels in emerging countries is made difficult by the political commitment to industrialization. While in developed countries, about a third of primary energy consumption is committed to electricity generation and more room exists to substitute electricity for transportation and residential purposes, in Asia and the Middle-East, industry, much of it fueled by oil liquids, makes up half of primary demand. For example, India, following the path of China and the petro-states of the Middle-East, is becoming a major global player in petrochemicals, using Russian and Persian Gulf feedstocks.

The difficulty of reducing CO2 emissions to address concerns with global warming can be illustrated by the example of the United States. Despite conservation efforts and the deployment of wind and solar, the consumption of liquid hydrocarbons has grown its share of U.S. primary energy consumption over the past decade and is at the same level as in 1980. This is because gas has replaced coal for generating electricity. In terms of “clean” energies, nuclear output has been frozen since the mid-1990s while renewables have doubled their share to 13.5% since 2000. This evolution is shown in the chart below.

The exceptionally low cost of gas in the US and the low cost of capital, particularly over the past 15 years, has enabled a relatively smooth and affordable transition to cleaner fuels. Unfortunately, other countries don’t have this luxury. Except for France, which has embraced nuclear, in Europe, the transition is proving exceedingly costly and further undermining competitiveness. After decades of complacency, the cost of “green” politics has now become a big political issue in Germany.

Though China is highly committed to nuclear, it generates only 3% of its energy demand from this source. Also, despite massive political support for renewables, it meets only 13% of its demand from solar and wind, about the same as the US.

Other emerging markets do not have the financial or organizational capacity to follow China’s path because of much higher capital costs and the lack of local suppliers. These countries will find the transition to renewables prohibitively expensive unless prices for solar generation fall much further or the rich countries of the world hand out massive subsidies.

 

If China’s Boom is Over, Where Will Demand for Commodities Come From?

China’s economy has experienced a multi-decade period of high growth, similar to “miracle” surges previously witnessed by other countries. Today’s wealthy nations once went through these surges as well: the U.K., the U.S., and Germany in the late 19th century; and Japan in the early 20th century and again in the 1960s. Various developing countries have also seen periods of so-called “miracle” growth, such as Brazil and Mexico in the 1960s, and Korea, Taiwan, and Malaysia since the 1970s, with China starting its own in the 1990s. A significant contributor to these periods of accelerated growth is a broad and powerful one-time build-out of physical infrastructure. This will be especially true in China, which has witnessed one of the greatest construction booms in history.

The amount of infrastructure investment undertaken by China is breathtaking. For example, Shanghai had four crossings of the Huangpu River in 1980 and now boasts 17. Shanghai did not possess a subway system in 1980, and now it encompasses over 800 kilometers of lines, making it the world’s longest. China claims eight of the top ten longest subway systems globally, with a total extension of 9,700 kilometers across 45 cities. In comparison, the U.S. has 1,400 km of subway lines in 16 cities. Since 2000, China has constructed 38,000 km of high-speed train lines, more than tripling the amount built by Europe since 1980. China’s National Trunk Highway System, primarily built over the past 20 years, now totals 160,000 km, compared to the 70,000 km of the U.S. Interstate Highway System.

China’s construction boom over the past decades can be measured by its share of the world’s production of basic building materials. For example, China consistently produced more than half of the total world cement output over the past decade, securing 56% in 2019. China also commands a similar share of the world’s steel output, reaching 57% in 2020, according to the American Iron and Steel Institute (AISI). The chart below illustrates China’s increasing share of world steel output, surpassing the level the U.S. had at the end of World War II.

The following chart displays steel output since 1950, with China’s ramp-up beginning in 2000.

Major infrastructure expansions do not need to be repeated. For instance, New York City’s infrastructure (bridges, tunnels, highways, subway system) was largely completed by the 1920s, and the bulk of the U.S. highway system was constructed between 1959 and 1972. The London Underground and the Paris Metro were built before the First World War, and France established most of Europe’s best high-speed train network between 1980 and 2000. The chart below illustrates this historical process and how it has impacted the production of steel in countries undergoing these surges in investment. Steel production surged in Europe in the late 19th century (railroads, steamboats, bridges, etc.) and again in the 1920s and 1930s (automobile infrastructure) and finally in the post-World War II “Golden Years.” The U.S. followed a similar path but also had a massive expansion of automobile infrastructure in the 1950-1970 period due to suburbanization and interstate highways. Brazil experienced an infrastructure boom in the 1960-1980 period, as did Korea in the 1970s. Invariably, these booms come to an end, and steel output plateaus, tapers, and eventually decreases.

The following table presents this data in percentage terms, with the total increase in steel output for the previous ten years. The data shows that multi-decade expansions in steel output are not uncommon: Europe and Japan (1970-1900); U.S. (1970-1940); Japan (1930-1970); Germany (1950-1980); Brazil (1950-1990); and Korea (1950-2010). China has been expanding steel output since the 1950s, which provided a high base for the mammoth expansion since 1980. India has been growing output at a swift rate even before reforms were launched in the 1980s, and it is already, with over 100 million in annual steel output, at a much higher level than China was when it started its “miracle” phase of economic growth.

Eighty-seven percent of the increase in world steel production over the past 22 years occurred in China, raising the question of which countries can pick up the slack if China’s construction boom is over. The hope is that India and emerging Southeast Asia can step up. Assuming China’s steel output remains flat, to maintain the 3.5% annual increase in global steel demand of the past twenty years, it will be necessary for India, Vietnam, Indonesia, and a few more high-growth economies to more than double their steel output every decade.

 

The Persistent Decline of Latin American Competitiveness

In a globalized world, capital will flow to the countries that provide the best conditions for businesses to operate. The IMD business school in Lausanne, Switzerland conducts a survey annually to measure how well governments  “provide an environment characterized by efficient infrastructures, institutions, and policies that encourage sustainable value creation by enterprises.” This survey is particularly significant because previous efforts by the World Bank (Doing Business) and the World Economic Forum (World Competitiveness Report) have been abandoned. The latest editition of the IMD World Competitiveness Report provides more damning evidence of the poor performance of many emerging markets, particulalry those in Latin America.

The IMD survey focuses on the 64 countries considered most relevant for multinational businesses. The latest rankings are shown in the chart below. Of the 15 largest countries in the MSCI Emerging Markets Index, only seven make it in the top half of the rankings (Taiwan, Saudi Arabia, UAE, China, Malaysia, Korea and Thailand). The two  in the top quintile (Taiwan and UAE) are rich countries, only included in the EM Index because of market access issues. On the other hand, in the bottom quintile, there are eight EM countries (Philippines, Peru, Mexico, Colombia, Brazil, South Africa, Argentina and Venezuela). Every Latin American country, except for Chile,  is in the bottom quintile, and four are in the bottom decile (Colombia, Brazil, Argentina and Venezuela. (Latin American countries are in bold and remaining EM countries in red)

The poor performance of Latin America has worsened over time. This can be seen in the following chart that shows IMD rankings since 1997 in decile form. There is a pronounced deterioration in the region’s rankings over this period, particularly after the commodity boom of the mid-2000s and the Great Financial Crisis. The decline of Argentina, Brazil and Chile, all commodity producers suffering from acute “Dutch Disease” (the commodity curse), is most pronounced, but even Mexico with the great advantage of NAFTA, has done poorly over the past ten years.

In addition to the devastating effects of the boom-to-bust commodity boom (2002-2012), the region suffers from multiple ills.

  • Political turbulence throughout the region, with the important exception of Mexico.
  • Poorly designed economic policies, often anti-business and generally poorly executed and unsustained.
  • Rampant capital flight, as elites and middle classes seek the security of Miami, Lisbon, Dallas, Punta del Este, etc…
  • The onslaught of Asian mercantilists, dumping manufactured goods in Latin American domestic markets.
  • Rising wealth inequality, as governments are unable to formulate and/or execute policies to provide employment or income to large segments of the population.

 

Growth and Economic Complexity

Rich countries have complex economies, and poor countries get richer by increasing the technological content of what they produce. This requires many things, such as good institutions (e.g., law and order, property rights) as well as an educated population and research institutions that drive innovation. The Atlas of Economic Complexity (AEC) , a joint project of the Massachusetts Institute of Technology and Harvard University, provides  insight into the progress countries around the world are making towards increasing their innovative capacity by measuring the degree of complexity and diversity of what they produce for global markets.

The work of the AEC was summarized in the 2011 book The Atlas Of Economic Complexity: Mapping Paths To Prosperity,  by Ricardo Haussman and Cesar Hidalgo, and it is  periodically updated by the Harvard Growth Lab (link) and the Observatory of Economic Complexity (link). The AEC solves the complex problem of measuring technological advancement by focusing on the degree of complexity and the diversity of a country’s exports and comparing this over time and with trading partners.

The chart below uses the AEI data to compare the top 25 most “complex” economies of 1995 to those of 2021. Not surprisingly, the leaders  of the Economic Complexity Index (ECI) are mainly the highest income countries. But this is less true in 2020 when compared to 1998, as Asian and Eastern European middle-income countries are moving up the ranking.

 

Although the list is relatively stable, there are five changes: five entrants, China, Malaysia, Mexico,  Taiwan and Romania,  replacing  Canada, Norway, Spain, Netherlands and Brazil.

All of the new entrants are countries well integrated into regional or global trade value chains that import almost all their commodity needs, while three of the departees (Canada, Brazil, Norway) are commodity producers.  This is interesting because the period saw the commodity super-cycle (2002-2012),  which greatly boosted the incomes and exports of commodity producers. The drop in the rankings of these countries is evidence of the “commodity curse” at work, whereby commodity boom-to-bust cycles create economic turbulence with long-term debilitating effects. In 2020 there are no commodity producers in this top 25 group, unless one counts the United States, which, in any case, saw its ranking fall from 9th to 13th.

The significant deterioration suffered by commodity producing countries is shown in detail below. These include the highly financialized Anglo-Saxon economies (Canada, Australia, New Zealand and the United States); and the traditional emerging market commodity exporters (Brazil, Chile, Argentina, Peru, Indonesia and South Africa). Brazil shares some of the characteristics of the Anglo Saxons, as it is also a highly financialized economy suffering rapid deindustrialization.

The change in the rankings from 1995 to 2020 for commodity producers is shown below. Indonesia is the only commodity exporter with an improved ranking, no doubt because it has been influenced by the mercantilist policies followed by its neighbors in South East Asia.

The contrast with the manufacturing-export-focused economies of Asia and Eastern Europe is shown below. These are all countries that have benefited from free trade and regional integration policies.

 

Finally, the following chart highlights the different paths taken by Brazil, Mexico and Turkey. Brazil has deindustrialized dramatically since 1995 and further  increased its dependence on commodities. Moreover, it has rejected globalization and regional integration.  On the other hand, Mexico and Turkey have embraced regional integration and successfully found their place in global value chains.

 

 

Brazil’s Grievous Manufacturing Collapse

Brazil has become a posterchild for the Middle-Income Trap which hinders countries  no longer able to compete against low-wage countries but without the productivity growth to compete in the higher value added industries dominated by advanced economies. But little attention has been given to the related  economic phenomenon which strikes commodity producers – “Dutch Disease,” also known as the Natural Resource Curse. The combination of the two for Brazil  has caused crippling premature deindustrialization.

Brazil has suffered two severe bouts of “Dutch Disease.” The first during the commodity boom of the 1970s which was followed by the bust of the 1980s and a “lost decade” of economic stagnation. The second, during the 2001-2012 commodity super-cycle  driven by China’s “economic miracle, which was also followed by a long economic depression. These two commodity booms were marked by similar excesses — overvalued currencies, unsustainable consumer booms, excess fiscal spending and high levels of debt accumulation, a deterioration of governance and a rise in corruption. In their wakes, the booms left behind a debilitated manufacturing sector, high debt levels and lower growth prospects.

 

 

Brazil’s “Dutch Disease” has been worsened by the concurrent strong growth of the farming, mining and oil sectors — all productive and  capital intensive activities with a high degree of export competitiveness. The rapid growth of these sectors, and the discovery of the giant offshore pre-salt oil fields,  has strengthened the current account and caused a structural appreciation of the Brazilian real. The loss of competitiveness of Brazil’s manufacturing sector has been more than compensated by the increased production and dollar revenues of the growth sectors. Unfortunately, these successful sectors generate scarce jobs and lack the significant multiplier effects of the manufacturing sector.

The chart below shows manufacturing GDP as a percentage of GDP for both resource rich and resource poor countries in emerging markets. The declining trend for commodity exporters relative to commodity importers is notable, and Brazil stands out in particular.

 

In 1980, at the end of the 1970s commodity boom, Brazil was the dominant manufacturing power in emerging markets  (China surpassed Brazil’s production levels but was behind in terms of complexity and quality of manufacturing). The following chart from the World Bank shows manufacturing value added for the primary emerging markets (and France for comparative purposes) both for 1980 and 2021. The rise of China and the relative decline of Brazil are striking.

The same data is shown below with Brazil as the benchmark, to measure relative performance.  Over this period, China’s manufacturing value added went from two times Brazil’s to 31.3x, a relative increase of  15.7x. India went from 44% of Brazil’s level to 2.9x. Every single country in the chart has gained relative to Brazil. This includes commodity producers (highlighted in red) which also may have suffered Dutch Disease. Most striking are Indonesia and Malaysia which went from 15% of Brazil to 150%, and 8% to 56%, respectively, a testament to the Asian commitment to currency stability and manufacturing exports.

 

 

Finally, the following chart shows the decline in industrial employment in Brazil over the past decade. In 2019, according to World Bank data, only 20% of employment in Brazil was in industry, a decline from 23.4% in  1991. This places Brazil at a level similar to advanced rich countries with service-intensive economies. In Brazil these service jobs tend to be poorly paid and unproductive with very few opportunities for training and advancement.

Brazil’s manufacturing collapse has no easy solution. Brazil’s successful commodity exporters yield extensive political power, not the least with the oversized financial sector. Schemes like those adopted by Argentina, featuring  multi-tiered currencies and taxes on exporters are difficult to implement and have high costs. A return to high tariffs on imports would be highly unpopular. A mix of these policies is likely to be introduced by the new administration with elevated short-term costs and unclear long=term benefits.

Brazil and the Return of Neomercantilism

The principal challenge of emerging markets policy makers is to provide the business environment for private enterprise to invest in activities that generate sustainable and equitable growth.

When they fail to do this they face the crippling flight of both financial and human capital. The ease  of communications, travel and capital movements make it easier than ever for wealthy and cosmopolitan elites to move their families and capital abroad.

Human and financial  capital drain can be devastating for emerging markets. Some 4.5 million Indians,  generally well-educated, have immigrated to the U.S. and the U.K. since 1980, contributing greatly to these developed economies. Venezuela has lost most of its educated elite and middle class over the past 15 years, leaving the country with dire prospects of ever recovering the middle-income status it once enjoyed. The past decade of slow growth and political unrest in Latin America has caused massive  capital flight from historically more stable countries like Brazil and Chile.

Brazil, which in the past largely avoided the drain of human and financial capital, now faces an exodus, with Portugal and the U.S. as the favorite destinations. With the return to power of the leftist Lula — reenergized, more bitter and radical after his two-year prison confinement — this flight from Brazil is sure to accelerate.

Ironically, the policies proposed by Lula are no longer on the ideological extreme. On the contrary, the new government’s policy proposals – government support through subsidies and credit for industrial onshoring and green technologies, all justified under the banner of national security and sovereignty – are a carbon copy of those promoted by the Biden Administration in the U.S. Moreover, the quote below, which was made this week by President Biden, could have come out of Lula’s mouth

“What it’s about is giving working folks a chance. I’ve never been a big fan of trickledown economics. In the family I was raised in not a lot trickled down to our table. When the middle-class does well, everybody does well. I campaigned on build from the bottom and middle out and when that happens the poor have a chance up, the middle class does well, and the wealthy always do well.”

In many ways, Biden’s quote applies even more to Brazil than it does to the U.S., as Brazil’s has suffered more deindustrialization than the U.S., and its inequality is one of the worst in the world and worsening.

Brazil desperately needs a new policy framework which promotes investment in productive activities with jobs that provide a middle-class lifestyle, not the service jobs (e.g. food delivery) that have been the only source of jobs in recent years. Or else, it will continue deeper into a peripheral role as a  supplier of commodities, mainly to China. The core of any economic strategy has to be to improve the income of the mass of Brazilians that currently barely participate in the productive economy.

According to the World Inequality Database, the poorest 50% of Brazil’s populations have about 8% of the country’s income and none of its wealth.  The consequence of this is that Brazil is really two countries: one country of some 20 million people  who have the income level of southern Europeans and are genuine consumers; and another country of 200 million people – including  a large poor segment relying extensively on government handouts – that has little purchasing power. The charts below compares Brazil to other countries in this regard. With a little over 20% of its population able to consume, Brazil’s consumer market is small. Worse, it hasn’t grown much over the past twenty years, increasing only during commodity booms.

Given the size of its available market, Brazil does not underproduce. For example, production of motor vehicles per potential consumer is comparable to other countries. Given current circumstances opportunities for capturing foreign demand are scarce, so the only opportunity for growth would come from an increase in the population of consumers.

Brazil’s new government understands Brazil’s challenges and has ambitious plans to relaunch the economy through an active promoter-state. Unfortunately, it maintains its traditional penchant for doing this through state companies and a big-state mentality.

However, Lula’s main problem is that his Labor Party lacks credibility. Lula pretends that the rampant corruption and incompetent management of the last PT government (2002-2016) never happened, but for most Brazilians the memory of that period is still vivid. No one has forgotten that the previous PT government’s (2002-2016) efforts to implement similar policies were crippled by graft and poor execution, and expectations are high that the same will occur again.

The tragedy of Brazil is that it is likely to miss the boat again. It was a major loser of the past 40 years of neoliberalism and globalization (starting the process at its end with Finance Minister Paulo Guedes) and now, as the world turns to neomercantilism, it is unprepared to respond adequately.

 

 

 

 

 

The New Global Monetary Regime

The U.S. dollar has been the lynchpin of the global monetary system since the end of World War II, promoting the geopolitical strategic interests of the United States and serving as a “public good” to facilitate the globalization of trade and finance. However, today the rise of China and growing threats to globalization present significant challenges to the long-term hegemony of the dollar. At a time when China aims to change the present dollar-centric monetary order, the dynamics of economic and domestic political forces in the U.S. also put into question its usefulness.

The weight of the dollar in global central bank reserves peaked in 2000 and has been falling gradually since then (chart 1). Today, the global economy has returned to a state of multipolarity last seen prior to WW1 when both Germany and the United States threatened the hegemony of pound sterling. In terms of its share of global GDP and trade and its status as a primary creditor to the world, China’s desire to shape a less dollar-centric global monetary system is legitimate (chart 2). China today has become the largest trading partner of most countries around the world and is the dominant importer of most commodities, so it is not surprising, given growing tensions with the U.S., that it does not want to have to rely on dollars to transact foreign trade (chart 3)

Chart 1

Chart 2, Countries share of world GDP, trade and capital exports

Chart 3, The largest trading partner of countries around the world

The current dollar fiat global monetary order also has become a burden for the U.S. economy. Since the 1950s, the U.S. has gone from being the dominant manufacturing power and exporter of the world and its primary creditor to the present day hyper-financialized and speculative economy with net debts  of $30 trillion to the world. Moreover, the political mood in America has turned against the neoliberal policies of the past decades — anchored on the free flow of trade, capital and immigration and current account deficits  — which seriously undermined American labor.

The gradual strengthening of a multipolar global monetary order will add  instability and costs and further the geopolitical deterioration and rising inflation that we have seen so far in the 2020s. A world of less trade, more of it non-dollar centric, and declining global trade imbalances will be very different from the experience of past decades. Over the short-run, the  dollar’s strength is likely to continue, driven by its safe-haven status in unstable times and the diminished supply of dollars resulting from more balanced global trade. Over the longer term, the dollar could weaken considerably from its currently overvalued levels. A decline in dollar hegemony implies a weaker dollar over time, but it is good to remember that because of powerful network effects reserve currency regimes are very sticky (e.g.,  more reserves were still held in pound sterling than in dollars until 1963).

The 75-year U.S. dollar reserve currency system has been unique in terms of its global reach, but in myriad ways it appears to be following in the steps of the previous regimes centered around the pound sterling, the Dutch florin and others before it.  These currency regimes lasted for around a century going through distinct phases:

  1. Economic, trade and creditor dominance. Expansion of productive capacity and capital accumulation.
  2. Excess capital accumulation, leading to financialization and speculation at the expense of the productive sector.
  3. Economic decline, as new powers seek hegemony.

The  current dollar reserve currency regime has followed this pattern since its launch at the Bretton Woods Conference in 1944.

Bretton Woods I (1945-1971)

The U.S.  imposed a dollar-centric monetary system at the Bretton Woods Conference. Disregarding the argument made by John Maynard Keynes for a global bank that would resolve current account imbalances,  all currencies  were anchored to the dollar at a fixed price for gold. The U.S. came out of the war with by far the largest economy in the world, as a huge net creditor to the world and as the dominant manufacturing and trading nation, all of which secured reserve currency status for the dollar.

In the 1950s, the U.S. ran current account surpluses with its major global trading partners, which were largely rechanneled into aid and direct investments for the reconstruction of the war-torn economies of Europe and Asia. However, by the early 1960s, Japan and Europe had recovered and were running current account surpluses with the U.S., which were registered as increases in each country’s “gold” reserves held at the U.S Federal Reserve. Growing opposition to the system was best expressed by France’s finance minister Valerie Giscard D’Estaing who decried the “exorbitant privilege” enjoyed by the U.S. (the supposed advantage of paying for imports by printing dollars). The system showed its first crack when France sent a navy frigate to New York to repatriate its gold reserves. The depletion of U.S. gold reserves at a time of “American malaise” (e.g., political assassinations, racial riots, the Vietnam War fiasco), led President Richard Nixon to “close the gold window”  in 1971, putting an end to Bretton Woods I.

The Chaotic Interlude (1971-1980)

America’s insouciance with regards to unilaterally breaking the dollar’s tie to gold and imposing a pure fiat currency system was expressed by Treasury Secretary John Connally’s comment, “it’s our currency but it’s your problem.” The result was a collapse of confidence in American monetary stewardship and a flight to dollar alternatives. Dollars as a percentage of total central bank reserves fell from 50% in 1971 to 25% in 1980, replaced mainly by gold but also by Deutsche mark and Japanese yen.

The Petrodollar System and The Golden Age of the dollar (1980-2000)

An agreement between Saudi Arabia and the United States in 1974 (the U.S. Saudi Arabian Joint-Commission on Economic Cooperation) committed Saudi Arabia to invoice petroleum sales in U.S. dollars and hold current account surpluses in U.S. Treasuries in exchange for defense guarantees and economic support. The pact  guaranteed ample global demand for dollars and reinstated America’s  “exorbitant privilege”  of running perpetual current account deficits (chart 3).

Fed chairman Paul Volcker’s success in quelling inflation and President Ronal Reagan’s neoliberal pro-business agenda put an end to the 1970s malaise and set the stage for the golden age of the dollar. This period was characterized by a persistent decline in inflation and interest rates, underpinned by stable prices for oil and gold and deflationary forces from both domestic sources (deregulation, lower taxes, decline of unions, immigration) and international sources (globalization, lower tariffs, free flow of capital) (chart 4)

Confidence in the dollar returned and central banks increased the weight of dollar reserves, from a low of 25% in 1980 to a peak of 60% in 2000, while gold reserves fell from 60% in 1980 to 12% in 2000. Low and declining inflation gave birth to the Fed’s “great moderation” thesis and allowed it to promote the great financialization of the economy, all buttressed by growing current account deficits and foreign capital inflows. With Wall Street at the core of the process, this period saw the U.S. become a huge net debtor as foreign countries accumulated surpluses and became the financiers of U.S. debt and other assets. This period also saw the widespread elimination of capital controls around the world and the growing influence of “hot money” tourist capital flows into foreign assets (chart 5).

Chart 5

Bretton Woods II (2000-2012)

China’s “opening up” under Deng Xiaoping during the 1980s, the maxi-devaluation of the RMB in 1994 and accession to the WTO in 2000 drove China’s “economic miracle” and the commodity super-cycle (2002-2012). China’s rise inaugurated a new global monetary regime which has been dubbed Bretton Woods II. Like in Bretton Woods I, the U.S. promoted the growth of a potential rival through trade and investment (under the premise that China would become more democratic and market-oriented over time).  Once again imbalances emerged, as China’s mercantilist policies led to massive current account surpluses with the U.S. which were parked in U.S. Treasury bills.  “Chimerica,” as the symbiotic relationship came to be known, made China the factory floor for the U.S. consumer.  The China “trade shock” accentuated the deflationary forces of the 1990s. This enabled the Federal Reserve to pursue loose monetary policy despite soaring commodity prices, which broke the “petrodollar” anchor of price stability of the prior twenty years.

Without the stability of the price of oil and gold that was at the core of the “Petrodollar system” Bretton Woods II was an anchorless pure Fiat Reserve Currency Model relying entirely on the faith and credit of the Federal Reserve. Since 2000, recurring financial crises (2001, 2007, 2020) have been met by a desperate and increasingly unorthodox Federal Reserve determined to combat deflationary forces by supporting extremely high levels of debt and equity prices through quantitative easing and international swap lines.

Rising tensions between China and the U.S. since Xi Jinping took power in China in 2011 have undermined “Chimerica.” Since 2017, China has been reducing its holdings of Treasury bills, and no longer recycles its current account surpluses into Treasury bills.  The sanctions imposed on Russia after the invasion of Ukraine and acrimonious relations with Saudi Arabia have further undermined the appeal of recycling current account surpluses into Treasuries.

In Search of a New Regime: Bretton Woods III?

 As Nobel Laureate Joseph Stiglitz has said, “the system in which the dollar is the reserve currency is a system that has long  been recognized to be unsustainable in the long run.” Eventually the “exorbitant privilege” and its geopolitical benefits turn into an “exorbitant burden” of deindustrialization and foreign liabilities.  Moreover, for the first time since WWII, the world’s largest trading nation, China, does not support the  regime. This raises the question of what comes next?

China has declared its determination to move the current world monetary order towards a less U.S. centric model. Given the deterioration in China-U.S. relations and the prospect of economic decoupling, it is likely that China’s trade and current account surpluses with the U.S. will dwindle over the next decade.  Without a reliable substitute for the U.S. consumer, China now aspires to a symbiotic relationship with natural resource producers, whereby it ‘barters” manufactured goods in exchange for commodities. China’s rapprochement with Russia and its diplomatic advances in the Persian Gulf and the steppes of Central Asia are evidence of this focus on creating a new global payments system which focuses on commodities and bypasses the highly financialized dollar correspondent network promoted by the U.S. China aspires to do the same with large economies like Brazil and Indonesia. A Xi visit to Saudi Arabia, rumored to be scheduled for next month, would be of great concern to Washington.

Zolltan Pozsar of Credit Suisse has recently written about a new global commodity anchored reserve currency model which he calls Bretton Woods III. The idea is that in a world torn by geopolitics, sanctions and financial instability  countries will do more trade in other currencies than the dollar and prefer to hold reserves in commodities. Geopolitical tensions this year  — Russia’s invasion of Ukraine and the imposition of sanctions on its trade and foreign reserves, and growing tension in the Taiwan Strait which have resulted  in the  imposition of draconian controls by the U.S. on semiconductor exports  — may have been a watershed which will accelerate financial decoupling.

Does China want the renminbi to serve as a reserve currency?

China, at least in the short run, “wants to have its cake and eat it too.”

China would like to reduce its vulnerability to U.S. sanctions by promoting a new monetary order that is not dollar-centric and do this in a way that allows it to continue to expand its geopolitical influence on Asia and its primary trading partners, mainly commodity producers. However, facing a decade of low growth due to debt, a real estate crisis, poor demographics and plummeting productivity, it also wants to preserve the millions of jobs tied to exports of manufacturing goods. Like all Asian Tigers (Japan, Korea, Taiwan) it needs to pursue the mercantilist policies of the past: an undervalued currency and export subsidies. For now, these mercantilist tendencies imply current account surpluses, which would make it difficult for China to create the expansion of RMB liabilities required in a reserve currency system.

However, under the firm hand of Chairman Xi, China is now rapidly moving to a different economic model that is different from the one followed since the 1980s and at odds with the East Asian model. As it ages rapidly and faces a sharp decline in its workforce, China  will cease to be both the “factory of the world” and the major creditor to the world. This trend will accelerate this decade as China adopts widespread autarkic policies to reduce its vulnerability to potential sanctions from geopolitical adversaries. Over the next decade, China is likely to move to a less production-oriented and more consumer- and finance -oriented economy. This implies more balanced trade and more appropriate conditions for promoting the RMB as a reserve currency.

Conclusion

The move to a multipolar world and parallel monetary regimes will add instability to the global economy during the coming decade. Though declining global trade imbalances are positive in the medium run, the reduction in global dollar liquidity will support dollar strength at first but accelerate alternative reserve currency holdings over time. Commodities will probably play a more important role in future monetary regimes, which will benefit the major global commodity producers.

There is great uncertainty about the reshaping of a new monetary order, but certainty about one thing: more instability.  The quote from Stiglitz concludes: “The system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run. It’s a system that is fraying, but as it frays it can contribute a great deal to global instability, and the movement from a dollar to a two-currency or three-currency, a dollar – euro [sic], is a movement that will make things even more unstable.”

Winter is Here for Emerging Markets

The first half of 2022 has been another big disappointment for investors in emerging markets as EM stocks fell 17%. On the positive side, EM stocks did better than the S&P 500, which fell by 20% during this period. Unfortunately, the rest of the year does not look better. The environment is simply not positive for EM assets. I wrote in February that Winter was  coming  (link)   ; now we can say that we are in the thick of winter.

All the indicators that we look at to mark the investment climate point firmly to more trouble ahead. Let’s look at these one by one.

  1. King dollar – EM assets usually do poorly when the dollar strengthens, mainly because most EM countries are short dollars and because commodity prices tend to do poorly during these times. The dollar has been strong since 2012, and this has been an awful period for EM investors. The recent surge in the dollar caused by high global risk aversion and flight of capital into U.S. assets, is a huge headwind for EM. The charts below show  first the DXY (heavily weighed towards the euro and the yen) and second the MSCI EM currency index, both of which show the sustained run the dollar has had for 10 years.

2. Global dollar Liquidity – Risky assets like EM stocks and bonds do well when dollar liquidity is ample and poorly when it dries up. After the money printing orgy of 2021, the tide has ebbed. The charts below show: first, one measure of global liquidity (U.S. M2 plus central bank reserves held at the Fed);  and second, central bank reserves held a the Fed. Liquidity is now in free fall. Foreign reserves held at the Fed are also plummeting, as countries like China and Russia have dramatically reduced their positions for geopolitical reasons and other countries are fleeing the negative real yields of Treasury notes.

3. Yield spreads – The spread between the yield of U.S. high yield bonds and Treasury bonds is one of the best indicators of risk aversion and recession risk. Historically, rising spreads point to problems for EM. We can see in the next chart the recent rise in the spread. Moreover, the rise in the spread has been tempered by the benefit of high oil prices for oil companies. Stripping these out the spreads would be much higher.

 

4. The CRB Industrial Index – Commodity prices and in particular industrial commodity prices are a tried and true indicator ofmarket trends for EM assets. This has been even more so since the rise of China twenty years ago because China is the primary consumer of industrial commodities, and any slowdown in China now spreads rapidly to the rest of EM. The CRB index, shown in the chart below from Yardeni.com,  has turned down since February and now appears in free fall. The combination of high oil prices and low industrial metal prices is a very bad one for EM.

5. Copper price – Finally, the price of copper is a good indicator of global economic activity, as Dr. Copper is known to sniff out recessions earlier than most economists. Unfortunately, copper also appears in free fall now.

So, all the relevant indicators tells us we are in a winter storm. It is best to sit be the fire with cash in hand and wait for calmer times.

The Great Inflation Debate

The great investment debate of today is about the future course of inflation. Economists and investors are divided into the “inflationistas” and “deflationistas.” The former, “Team Permanent,” see the recent surge in inflation as indicative of a regime change towards a world of supply scarcity and higher prices.; the latter, “Team Transitory,” believe we are stuck in a low growth and demand-constrained environment where prices always fall unless monetary authorities intervene.

Until recently, the “deflationistas” were triumphant. Fears that the money printing and fiscal expansion that followed the Great Financial Crisis would spark inflation never materialized. The past ten years have been marked by low inflation and a strong dollar despite zero bound nominal interest rates. The core argument of the “Deflationistas,” as expressed by economist luminaries such as Paul Krugman and former Fed Chair Ben Bernanke, is that inflation is repressed by declining growth in the working age population. This phenomenon, sometimes called “secular stagnation” or also “the global savings glut” has supposedly  brought down the “natural rate of interest” which preserves price stability.

Deflation has been the norm for so long that it is understandable that most people assume that it  will persist.

Since the U.S. Consumer Price Index (CPI) peaked at 15% in the spring of 1980 it has been on a persistent downward trajectory. This has been dubbed “The Great Moderation” by Bernanke  who attributed this result to the masterful management of the Fed and  its 400 economists.

The contribution of the Fed to the deflation process is difficult to confirm because of the various other factors that have concurrently impacted prices over the period. These are well known, but we list them below:

  1. The collapse in commodity prices. Energy prices fell by 80% during the 1980s and remained low until 2002. Following the GFC, the U.S. shale revolution drove energy costs in the U.S. to near record lows.
  2. The baby boom labor expansion which was magnified by a huge increase of the female participation rate in the labor force, and also by record levels of legal and illegal immigration.
  3. The rise of China under Deng (1982) and the fall of the Berlin Wall (1989), which added nearly a billion low-cost workers to the global economy. China’s debt-fueled mercantilist industrial promotion policies also dramatically increased global production capacity for a wide variety of industrial goods.
  4. Hyper-globalization, driven by declining transportation and communication costs and chronic U.S. current account deficits. Outsourcing has been highly deflationary, lowering labor costs of goods and putting downward pressure on domestic wages.
  5. Hyper-financialization, driven by the Washington Consensus for open global capital and labor markets.
  6. The Reagan-Thatcher Neoliberal Revolution which drove prices down through deregulation, the defenestration of labor unions and lower taxes.
  7. Lax anti-trust policy which incentivized corporate concentration . This was further accentuated by the emergence of  “winner-take-all” network-driven technology business models.
  8. Digitalization of consumption through technology.

Over this long 40-year deflationary period, different forces have dominated at different times. For example, in the 80s declining commodity prices, deregulation and abundant labor were the dominating forces. However, in the 00s, the “China supply shock” (including cheap Chinese labor) and hyper-financialization were the dominant forces, overwhelming the temporary surge in commodity prices.

Some of these deflationary forces are still operative today. Foremost, technology continues to be deflationary as digitalization spreads wider (entertainment, office work, medicine, etc…) and communications facilitate offshoring (eg. IT in Bangalore). Supposedly accelerating technological disruption is now the key argument of many deflationistas (e.g. Cathie Wood of Ark Investments), even though over the past decades this was probably of secondary importance to the overall deflationary trend.

There is also a major new source of deflation, which is the high levels of debt accumulated around the world and, consequently, the collapse in “money velocity” (the creation of money through commercial bank lending). Though this is a controversial topic with economists, there are reasons to believe that the very high levels of debt around the world repress future economic growth. This is manifested by the decline in the money expansion created by bank lending over the past decades, and it explains why quantitative easing has had little impact on consumer prices. It may well be that debt levels are so high that any effort to raise real interest rates by central banks will tank economies. This view, pushed by the investor Ray Dalio, assumes that we have reached the peak of a long-term debt cycle.

On the other hand, there are new inflationary forces and some of the powerful deflationary forces of recent decades may have lost steam. These inflationary  factors can be listed as follows:

  • Commodity prices have surged recently and may continue to rise because of underinvestment caused by regulations and ESG lobbying. The shale revolution in the U.S. may have peaked out and may no longer provide a source of low-cost marginal production.
  • Labor in developed countries is now tight because of ageing populations, a decline in female participation rates and anti-immigration policies. The working age populations in most developed countries and in China are now in steep decline which should increase the cost of labor if productivity does not compensate.
  • Hyperglobalization may be under threat as reliance on China and other Asian manufacturing hubs is increasingly seen as irresponsible in an increasingly fraught geopolitical environment.
  • Hyperfinancialization is under question as unfettered capital flows have proven to be highly disruptive for both the United States and most emerging markets. Over this long deflationary period, chronic current account deficits have made the U.S. a net debtor to the world with a Net International Financial position going from positive 10% of GDP in 1981 to negative 86% of GDP in 2021.
  • The neoliberal revolution may have exhausted itself. Labor unions are showing signs of making a comeback and tax cuts have resulted in chronic deficits and record debt levels. Also, there is a growing realization that without government interference the U.S stands to lose jobs and stature to countries which actively support industries through subsidies and mercantilist policies (e.g. semiconductor manufacturing which may soon disappear from the U.S. unless the government supports it). Moreover, there are some signs of a resurgence in anti-trust efforts from Washington.

The debate between the “deflationistas” and the “inflationistas” will not be settled anytime soon. There are simply too many moving pieces and competitive forces at work to have high conviction now. Nevertheless, for the first time in decades the Fed may no longer have the wind at its back and the luxury to print trillions of dollars to support economic activity and financial markets. If the Fed is faced  with the choice between supporting the economy and financial markets or controlling inflation, political pressures will guide its decisions. In a world of populist politics this may mean higher prices in exchange for more government spending and higher wages.

The charts below show the inflation story in pictures.

Deflation has been a global trend since the 1980s.

But has also recently has been on the rise everywhere.

 

Commodity prices (relative to inflation) were extremely deflationary between 1980-2000 and 2012-2020, but are also rising sharply now.

 

The impact of deregulation on freight rail  rates.

The defenestration of labor unions.

 

Outsourcing has shifted share of GDP from workers to corporations.

The rate of growth of the working age population has collapsed.

Money velocity has collapsed as debt levels increase.

 

 

 

High Commodity Prices for Brazil Probably Mean Another Wave of Dutch Disease

It is an unfortunate reality that for most countries natural resource wealth is counterproductive. This phenomenon is known in economics as “Dutch Disease,” in reference to the Dutch natural gas boom in the 1960s which resulted in currency overvaluation, declining manufacturing exports ,  higher unemployment and lower GDP growth.

In the Post W.W. II period, which has been marked by declining trade transaction costs and more open borders, few countries have avoided the resource curse. Norway, having learned from the Dutch experience, carefully managed the windfall from its oil boom in the 1970s by creating a Sovereign Wealth Fund to distribute benefits over generations. The United Arab Emirates has also squirreled away oil income into Sovereign Funds which make long-term investments to reduce dependence on finite oil resources.

In emerging markets it is difficult to exercise this discipline because of weak institutions and the pressing needs of the poor. Rent-seeking elites, crony capitalists and corrupt politicians inevitably take advantage of this institutional fragility to appropriate a disproportionate share of the resource windfall.

Brazil is perhaps the best recent example of the curse at work. A discovery of very large offshore oil reserves in 2006 was expected to be transformational for a country with a history oil deficiency. Predictions were made for an expansion of oil production from 2 million b/d to over 7 million over the next decade. The discovery sparked a euphoric mood, and  investors and policy makers projected positive effects on GDP growth, fiscal accounts and the balance of payments.

Brazil’s oil discovery  turbo-charged the commodity super-cycle (2002-2010),  which was already underway,  causing  a positive terms of trade shock, currency appreciation, and a massive credit boom. Instead of saving for the future, the government dramatically increased spending on social welfare programs and public sector benefits.

Unfortunately, the commodity boom brought all the negative consequences which are associated with “Dutch disease.”

  1. Worsening governance and corruption

The commodity boom brought forth the worse tendencies of  Brazilian governance,  well described by former Central Bank president Gustavo Franco as “An obese state  fully captured  by parasites and opportunists always  fixated on protecting their turf.”  We can see how governance (government effectiveness), as measured by the World Bank, deteriorated in the following chart.

Corruption also reached unprecedented levels over this period, as measured by the World Bank.

  1.  Currency appreciation followed by eventual depreciation.  Instead of squirrelling away the commodity windfall, Brazil allowed the currency to sharply appreciate. International reserves were also increased significantly, but without sterilizing the impact on domestic supply, which fueled credit growth.

 

  1. Deindustrialization

The huge appreciation of the BRL caused an accelerated loss of competitiveness of the manufacturing sector, which we can see in the fall of manufacturing share of GDP and an accelerated decline in manufacturing complexity. The first chart below shows the evolution of manufacturing value-added  as a share of GDP for resource-rich economies  compared with resource-poor economies, highlighting that Dutch Disease impacted all commodity exporters. The next two charts also show the evolution of manufacturing by comparing economic complexity in Latin America and  Asia.

  1. Lower Potential Growth. The erosion of manufacturing capacity led to massive replacement of “quality” industry jobs with low valued-added service jobs, and, consequently, a collapse in productivity. Potential GDP growth was about 2.5% annually before the commodity boom and has now fallen to less than 1.5%. As shown below, over the past decade total factor productivity has collapsed in Brazil.

 

 

As a result of this aggravated case of Dutch Disease, Brazil is more than ever dependent on its world class natural resource sectors: export-oriented farming, and export-oriented mining. Both of these sectors are highly competitive globally but very technology and capital intensive , providing  few jobs (Vale’s enormous iron ore operations generate only 40,000 jobs in Brazil.) Paradoxically, Brazil’s  farm sector has similarities with South-East Asia’s “Tiger” economies. Like in Taiwan, Korea and China, Brazilian farmers have benefited from ample credit,  state R&D support and export subsidies.

Ironically, current prospects for rising commodity prices are not necessarily  good news for Brazil as there  is no evidence that lessons have been learned from the past.

The Cycle is Turning; Winter is Coming

Since the outset of the pandemic the global economic cycle has been in accelerated mode. We witnessed one of the shortest downcycles ever and the quickest recovery of employment for any recession in decades. By the middle of last year, the U.S. economy showed clear signs of mid-to-late  cycle behavior, with low employment and rising prices. Now, we are clearly late cycle, with Central Banks having to tighten monetary policy and yield curves flattening underway.

Asset prices have behaved as expected both on the way down and the way up: risk assets (value, small caps, cyclicals) did very poorly on the way down and then very well on the way up. Defensive assets such as quality growth held up on the way down, underperformed on the way up and have proved resilient in the current late phase. Increasing volatility in asset prices and the collapse of speculative bubbles are also signs of a cycle end.

We are now seeing the cycle go full circle, with the typical signs of contraction appearing.

Leading Economic Indicators are pointing down, as shown in the charts below. The first chart is the OECD’s global LEI; the second chart shows LEIs for the U.S. and Korea, the two most important bellwethers of the global growth cycle.

Dr. Copper, also famous for his ability to predict global cycles, also is signaling problems ahead.

The implication is that we are entering a risk-off phase when investors will shun value, small caps and cyclicals. Of course, this includes emerging markets, particularly non-China assets. This will create the next good buying opportunity.

A Tale of Two Decades For Emerging Markets

For investors in emerging markets, the past decade has been a mirror image of the previous one. The S&P500 treaded water between 2001-2010, at first held back by the hangover of the technology-media-telecom bubble and then crashing with the Great Financial Crisis. Emerging markets, on the other hand, benefited from the peak growth years of the Chinese economic miracle and the commodity super-cycle that it engendered, and sailed through the GFC thanks to the extraordinary stimulus measures adopted by China. Over the past ten years, the opposite has happened. Emerging markets have languished as the U.S. dollar went from weak to strong, commodity prices collapsed and the pace and quality of China’s growth worsened. U.S. stocks, on the other hand, were turbocharged by waves of Quantitative Easing, which channeled liquidity into financial assets,  deflationary forces and the remarkable maturation of America’s tech monoliths into cash-generating machines.

We can see this evolution clearly in the following chart, which includes the EAFE index (Europe, Asia, Far East developed markets) and the Dow Index, in addition to the FTSE EM Index and the S&P500. The EAFE index is the biggest loser over the combined period, as it was hit hard by the GFC and lagged in the recovery. These two periods can also be explained in terms of the performance of the dollar and the nature of the components of the different indices. Non-U.S. developed market currencies appreciated nearly 40% over the first period and lost 20% over the second period, while EM currencies appreciated by 33% and then fell by 30%.

In terms of index components, EM and EAFE (and the Dow) are weighted towards cyclical stocks (industry, commodities and banks) much more than the tech heavy S&P500. This means that, to a significant degree, the relative performance of these indices can be considered in terms of the  value-growth style factors. Traditional value stocks performed well in the first period and miserably in the second.

 

How can we explain the poor performance of cyclical stocks over the past decade?  Probably the answer lies in several coincident developments in the world economy that have resulted in excess capacity and low demand for commodities and industrial goods:

  • The great financialization of the global economy, which peaked with the Great Financial Crisis, has sapped investment and growth at a time when rich countries are ageing and losing dynamism. Debt-to-GDP ratios are at peak historical levels in most developed and EM countries with not much to show in terms of productive investments.
  • The end of China’s economic miracle. Since the GFC, China’s authorities have mainly concerned themselves, with little success, with correcting growing economic imbalances. Efforts to boost consumption and reduce dependence on non-productive investments have not been successful.
  • The 2001-2011 decade left many industries and commodity producers with excess capacity. The commodity super-cycle turned out to be much more of a bane then a boom for commodity dependent economies which subsequently have suffered from a heavy dose of “Dutch Disease.” (Brazil, South Africa, Chile, Indonesia)
  • Technological disruption is hitting many of the traditional cyclical industries (banking, autos).

The combination of these factors have led to a state of quasi-depression for most emerging markets over the past decade. We can see this in earnings growth over the two decades, as shown in the following charts.

The 2001-2011 decade was outstanding for corporate earnings, particularly for countries highly engaged in the China trade (Chile, South Africa, Indonesia, Korea). The U.S. lagged considerably, worse than appears on the chart because the base for the U.S. is the trough of the 2001 U.S. recession.

The chart for the 2011-2021 period paints a very different picture. The beneficiaries of the China trade of the previous decade all suffer deeply from a combination of “Dutch Disease,” terms-of-trade shocks and global excess capacity. Almost all the countries show low to negative earnings growth over the decade, the exceptions being the U.S. (strong dollar and tech stocks) and Taiwan (TSMC).

The past decade has seen a revival of “American exceptionalism,” premised on the relative strength of U.S. capitalism and economic dynamism compared to the rest of the world. The unique capacity of American venture capitalism, Washington’s pro-business and pro-Wall Street stance, the ocean of liquidity provided by the Federal Reserve and its perceived commitment to backstop equity markets, and corporate America’s keen focus on shareholder value have made America’s stock market the magnet for international capital looking for safety in a turbulent world.

Chile’s New Reality; from Tiger to Sloth

In the past, Chile was considered a rare economic success story in emerging markets,  in the same vein as the high-growth “Tigers”  of East Asia. After the neo-liberal reforms introduced by the “Chicago Boys” of the military dictatorship (1973-1990), Chile enjoyed high GDP growth and significant improvements in social indicators. However, in recent years progress has stalled and Chile has started to look a lot more like its regional neighbors than like an East Asia tiger. Moreover, this process of convergence with the region is expected to accelerate in the near term as a constitutional assembly approves a new progressive constitution that is expected to greatly increase social rights and benefits and undo much of the  neoliberal economic framework imposed during  the military regime. Undoubtedly, these important changes will impact growth and the investment environment. Investors would be negligent to not incorporate this new reality into their analysis of business opportunities.

Chile’s growth path has been on a steady decline. Following about a decade of spectacular growth (1986-1997) the economy has gradually lost its dynamism.  Even during the commodity super-cycle of (2003-2012), growth levels were a step below the previous trend. Like in the rest of commodity-producing Latin America, the commodity boom was more a curse than a blessing, leaving behind high debt levels, an overvalued currency and deteriorated governance.  Since the commodity bust in 2012, the country has entered a low growth path and faces increasing social instability resulting from the unmet high expectations generated during the boom years. The chart below shows Chile’s GDP growth path since 1980 and the IMF World Economic Outlook projections through 2026. The IMF now sees Chile’s sustainable GDP growth path to be around 2.5%, which is only slightly above the regional average and a fraction of previous growth. Moreover, the IMF’s numbers do not yet take into account the considerable economic disruption that will probably result from the upcoming constitutional reform.

The marked reduction in growth prospects for Chile will mean lower corporate profit growth and impact  stock market valuations.  We can look at history to put this in context.

The first chart below shows the performance of stocks on the Santiago exchange for the very long term (1894-2021). We can see a long decline from the 1890s through 1960, and then a more precipitous decline caused by the political agitation of the 1960s and the rise to power in 1970 of the socialist,  Salvador Allende. The concurrence of the military coup in 1973 and a boom in commodity prices led to a huge stock market rally in the 1970s, with the index rising by 125 times (a dollar invested in 1970 would have appreciated to 125 dollars in 1980). Then came the collapse in  commodity prices and the Latin American debt crisis, and the market lost 86% of its value before stabilizing in December 1984. From that low point the market would rally 33.5x before topping in July 1995. In retrospect, we can say that 1995 was the glorious peak for Chilean stocks. The stock market provided dollarized annualized returns of 39.6% between 1973 and 1994. Between 1994 and today annualized returns have been a measly 1.9% (These numbers are before dividends which increase returns by about 2% per year). About 70% of contributors to the Chilean Pension fund system joined after 1994 and therefore have experienced low returns on their investments in Chilean stocks.

The following chart shows the more recent performance in greater detail. We can see that the 1994 peak was built on a period of rising earnings and rising PE multiples, with the PE reaching 26.4, the highest ever for Santiago. The commodity boom  bull market (2002-2012) was built essentially on USD earnings growth, a combination of corporate earnings and a strengthening peso. Since the commodity bust in 2012,  USD earnings have fallen by half because of a combination of lower corporate earnings and a weakening peso. Nominal USD earnings today are at the same level as 14 years ago.

We can shed more light on valuations by considering cyclically-adjusted Price-Earnings ratios (CAPE)  for the Chilean market.  What we see here is that Chilean stocks have had two “bubbles” over the past 30 years: first in 1994, based on the extrapolation of the “miracle” economy and optimism on the transition to democracy; second in 2007-2010, when the commodity super-cycle drove up both USD earnings and multiples.

 

What do these numbers tell us about future returns? First, we can see that current CAPE  earnings are about 20%  below trend. Second, we see that the cape ratio is well below the trend-line which is also in sync with the historical median CAPE for Chile of 17.9. Assuming a return to earnings trend in several years and the historical median CAPE ratio, Chilean stocks would have nearly 80% upside from current levels.

This is the normal analysis done with CAPE. Fraught as it is with problems, it does generally provide a reasonable indicator of return potential. But perhaps the case of Chile does not fit into this easy analysis.

First, the historical median cape may be distorted by two periods of extraordinarily high CAPEs over the 30-year period, during the 1994 and the 2007-2012 bubbles. What if current CAPE ratios reflect more realistically Chile’s current prospects of low growth? Second, perhaps the earnings trendline should be sloping downwards to take into consideration these diminishing growth expectations. No one believes that Chile can return to the kind of growth it saw in the 1990s. On the contrary, the low GDP growth expected by the IMF is in line with consensus and may even be optimistic if the constitutional reform is as anti-business as many observers now fear.

The fact is that a return to normalcy is a low probability scenario. Investors have the difficult task of evaluating what the new Chilean growth model will look like and project expected returns on that basis.

The case of Chile illustrates one of the characteristic traps of emerging market investing. Sudden and radical changes in political and regulatory environments can completely undermine an investor’s valuation framework. We are currently seeing this in China where regulators have suddenly put in question the financial models of most of the prominent tech firms. In Chile, the protests of recent years and the prospects of constitutional reform have signaled the end of the pro-business neo-liberal regime, meaning that the high valuation multiples of the past are probably irrelevant.

Currency Wars, the Dollar and Emerging Markets

Worsening economic conditions in the United States point to a weaker dollar in the future. The combination of low GDP growth, high debt levels, unsustainable fiscal and current account deficits and an overvalued USD makes devaluation the path of least resistance. However, most of America’s trading partners either face equally poor monetary and fiscal challenges or are determined to avoid allowing their currencies to appreciate. This creates a stalemate in the currency wars which facilitates more money printing and debt accumulation, with the consequence that asset prices rise to compensate for currency debasement. Until this predicament changes, the currency adjustments that a healthy and balanced global financial system would produce are not likely to occur.

At the heart of this dilemma lie on one side the mercantilist economies that repress consumption to promote exports (China, Japan, Korea, Taiwan, Germany) and on the other the Anglo-Saxon economies that promote consumption and accept persistent current account deficits (United States, United Kingdom, Canada, Australia). These conditions have persisted for decades because on each side powerful interests assert their influence to preserve them: in the case of the mercantilist, the manufacturing lobby; in the Anglo-Saxon economies, the banks which benefit from the financialization of the economy.  Germany conveniently benefits from the euro which is structurally undervalued to support the weaker economies of the region.

The following table illustrates the current currency panorama and gives some insights on a few potential trading opportunities at the present time. The first column shows the deviation of the Real Effective Exchange Rate (REER) from the 30-year median level for the major EM countries and also the primary trading partners of the United States. The currencies above 100% are expensive relative to the median level of the past 30 years. This group is extremely heterogeneous. We would expect high-growth and productive exporters (China, Vietnam, Thailand, Korea, Taiwan and Poland) to have appreciating currencies over time, and that is what we see here. However, all these countries are bent on maintaining competitive currencies and current account surpluses. These economies all have strong fundamentals and moderate twin deficits (current account plus fiscal account). The remaining countries with currencies above the 30-year median face more problematic circumstances. India, the Philippines, Nigeria, and the United States all have low productivity growth, chronic current account deficits and high twin deficits. These countries have all allowed their currencies to appreciate to the detriment of their export competitiveness, and all of them tend to favor finance over the manufacturing sector. In this second group, the currencies of the United States and India are propped up by financial capital flows.

At the other end of the table, we have the countries which have currencies at weak levels relative to the 30-year median REER. Most of the cheap currency countries have a history of high currency volatility, driven by commodity cycles and flows of speculative capital (“hot money”).  Argentina, Brazil, Russia, Colombia, Peru, Chile and South Africa are prematurely deindustrialized and dependent on exports of basic commodities that are increasingly capital intensive. The high levels of currency volatility are linked to boom-to-bust cycles, which disincentivize exports of manufacturing goods and increase dependence on commodities and debt accumulation. Typically, these countries will see significant currency appreciation during commodity upcycles, and, given how cheap the currencies are today, it is plausible this will happen again. The problem for these countries is that economic mismanagement and unproductive debt accumulation have left them with very high twin deficits and, consequently, very vulnerable to global financial volatility.

This leaves us with Malaysia, Mexico, Japan and Turkey. These four countries all have competitive currencies and are important participants in global manufacturing supply chains and stand to benefit from the current trend towards reshoring and restructuring of supply chains. Moreover, all of them except for Turkey, have sound economic fundamentals. These are probably the currencies with the most upside in a global synchronized economic recovery in 2022.  In the case of Turkey any progress towards stabilizing the economy could lead to significant currency appreciation.

Pinera’s Gambit has Caused an Earthquake in Chile

Politics are mainly about how to distribute wealth. In democracies, despite the lobbying influence of plutocrats, occasionally the people will vote for radical changes to laws and institutions to tear down existing structures and accelerate progress towards more egalitarian and socially progressive outcomes. This has now happened in Chile where the recent constitutional referendum and local elections have resulted in a cataclysmic earthquake for the conservative establishment.

In agreeing to a constitutional referendum, Chile’s President Sebastian had hoped to calm social unrest, under the assumption that traditional conservative forces would retain enough power in a constitutional assembly to moderate the result. The results of the May referendum have shown this to be a huge and costly miscalculation.

Pinera’s conservatives were obliterated in the election by an alliance of highly progressive candidates from the left, including traditional leftist (socialists, communists, etc…) and independents (greens, feminists, native Indian, LGBT).

This progressive coalition has a solid mandate to put a close to an era defined by the military regime of Augusto Pinochet, the “Chicago Boys” neo-liberal economic reforms of the 1970s and the conservative constitution of 1980.

The circumstances in Chile are reminiscent of the process that resulted in Brazil’s “peoples” constitution of 1988, with its 70,000 pages defining “citizens rights.”  The fiscal commitments enshrined in the new constitution have burdened the economy since then and are a major reason for decades of low GDP growth.

The Brazilian constitutional reform was led by leftist politicians who felt aggrieved by the policies of the military regime. Now, in Chile, the new wave of progressives are determined to do away with the legacy of Pinochet.

The primary grievance of Chile’s progressive is that the previous model was structured to benefit the conservative elite and its economic interests. Chile’s pro-business neoliberal model, which promoted open markets and low corporate taxes, will almost certainly be revised with a focus on social distribution. Also, Chile’s innovative privately-managed pension fund system is likely to be unwound and replaced by an expanded social security benefits.

The evolution of the private pension system over four decades of existence is emblematic of the sclerosis that came to characterize the Chilean conservative movement as policy makers came to be captured by the business elite. Initially considered a thoughtful innovation, the system over time has been ineffective because of high costs and low returns. The system should have been reformed years ago but was not. The final nail for the AFPs was the dismal returns over the past decade, as shown below.

In fact, much of what has happened with the AFPs and with Chile in general should be seen in the context of the aftermath of the commodity super-cycle which ended in 2012. Chile, like most commodity producers, underwent a typical boom-t0-bust economic cycle and the consequent “Dutch Disease”: first, financial speculation (e.g. real estate), debt accumulation, overvalued currency, complacency of policy makers; followed by over-indebtedness, currency weakness and capital flight. The bust-phase of the past ten years has caused a deep social malaise for a young and educated population with high expectations, leading to a feeling of disenfranchisement and the recent street protests.

The irony is that a new commodity upcycle may now have started. Pinera’s gambit will have been tragically mistimed.

Global Liquidity, For Now, is Flooding Emerging Markets

The extraordinary policies implemented this year by the the U.S. Fed and fellow central bankers around the world have flooded the global economy with liquidity. In addition to jacking up asset prices and enriching the holders of financial assets around the world, extremely loose financial conditions may have triggered a change in global economic conditions towards a weaker U.S. dollar and, consequently, higher commodity prices and better prospects for emerging markets asset prices.

Global U.S. dollar liquidity, as measured by U.S. money supply (M2) added to  foreign reserves held in custody at the Federal Reserve, has risen at the fastest pace ever recorded over the past year.  This indicator in the past has been a very good measure of global financial conditions and is strongly correlated to economic and financial conditions in the typically “dollar short” emerging markets. The chart below shows the evolution of this indicator over time, measured in terms of year-on-year real growth. The indicator  shows clearly the loose conditions during the 2002-2012 commodity supercycle which was a period of very robust performance for EM assets. On the other hand,  liquidity has been tight since 2012 (when the commodity-supercycle ended), only interrupted by brief expansions in 2014 and 2016. This period of tight global dollar liquidity resulted in very poor conditions for emerging markets, particularly for those cyclical economies outside of NE Asia .  Interestingly,  during this long downtrend emerging market stocks had two brief periods of strength, in 2014 and 2016. Not surprisingly, the outperformance of EM stocks since April of this year has happened concurrently with a massive expansion of global liquidity.

Increased U.S. money supply, particularly at times of low growth and gaping fiscal and current account deficits, tends to be associated with a weak USD. In the past we have seen that during these periods major emerging markets, either because they practice persistent mercantilistic policies (Korea, Taiwan, China) or because they introduce “defensive” anti-cyclical measures aimed at avoiding the negative effects of “hot money”  (Brazil), have accumulated foreign reserves which they hold in Treasuries at the U.S. Fed. The effects on domestic monetary policies that these efforts to manipulate currencies bring about are very difficult to neutralize and have invariably led to strong expansions in money and credit in domestic economies. This occurred  intensively in the 2005-2012  period and was the primary cause of the great EM stock bubble. The opposite has taken place since 2012, with foreign reserves declining and tight credit conditions existing  in most EM countries. The charts below show : 1, the progression in foreign reserves held in custody at the U.S. Fed; and 2, the year-on-year growth in these reserves.

Note the recent uptick in the second chart which indicates a recent turn in the trend of foreign reserve accumulation. This upturn has been caused by the large current account deficits that the U.S. has had with Asia this year while it has sustained consumption of imported goods through fiscal and monetary policies while both the consumption of domestic goods (services) and manufacturing were stifled by Covid.

Is a Repeat of the 2000s in the Cards for Emerging Markets?

The current expansion of global liquidity and the weakening USD are unquestionably bullish for emerging markets. However, there are several  reasons to believe that the conditions do not exist for an emerging market super-boom like we saw in the 2000s.

First, the U.S. has clearly evolved in its awareness of the negative effects that unfettered globalization has had on its working class. This means it now has much less tolerance for the mercantilistic currency manipulation practiced by allies (e.g., Korea, Taiwan) and zero tolerance for those practiced by strategic rivals (China).  This reality is shown by the increasing attention given to the U.S. Treasury’s bi-annual Currency Manipulator Watchlist Report which this week added India and Vietnam, in addition to China, Japan, Korea, Germany, Italy, Singapore, Malaysia, Taiwan, Thailand, and India. Most of these countries are close strategic allies of the U.S. that in the past had been given a free-pass, but that is not likely to be the case in the future. Until now, the U.S. has not used the Watchlist to impose sanctions on trading partners,  but the mood in Washington has changed and we will see what attitude the Biden Administration assumes.

This means that countries may no longer be allowed to run large current account surpluses and accumulate foreign reserves. It may also mean that countries that are subject to highly cyclical inflow of hot money will  be restricted in accumulating reserves, like Brazil did in the 2000s.  In that case, they will have to turn to some sort of capital controls to regulate flows.

Second, emerging markets are much more indebted than they were 15-20 years ago when the previous cycle started. This means that even if countries were allowed to manipulate their currencies, the domestic economies have much less room to absorb credit expansion without creating instability.

Finally, though valuations in EM are lower than for the bubbly U.S. market, they are much higher than they were in the early 2000s.

In conclusion, the 2020s will probably not look much like the 2000s. The U.S. is likely to be a much more cantankerous partner, and one much less willing to assume the costs of globalization.

 

 

 

The Next Commodity Cycle and Emerging Markets

 

The stars may be aligned for a new cycle of rising prices for industrial and agricultural commodities. It has been nine years since the 2002-2011 “supercycle” peaked, and the malinvestment and overcapacity from that period has been largely washed out. Over the past several months, despite economic recession around the world, commodity prices have started to rise in response to supply disruptions and the anticipation of a strong global synchronized recovery in 2021. Moreover, in recent weeks the victory of Joe Biden in the U.S. elections has raised the prospect of a combination of loose monetary policy and robust fiscal policy, with the added benefit that a good part of the fiscal largess will be directed to infrastructure and “green” targets which will increase demand for key commodities. Finally, global demographics are once again becoming supportive of demand.

The chart below shows 25 years of price history for the CRB Raw Industrials Spot Index and the Copper Spot Index. Not surprisingly, these indices follow the same path. Interestingly, they are also closely linked with emerging markets stocks. This is is shown in the second chart. (VEIEX, FTSE EM Index). This is clear evidence of the highly cyclical nature of EM investing, and it is the explanation for why EM stocks outperform mainly when global growth is strong,  commodity prices are rising and the USD is declining.

Since the early 2000s, China has been the force driving global growth and the cyclical dynamic. Since that time China has been responsible for generating most of the incremental demand for commodities. Starting in 1994, China embarked on a twenty-year stretch of very high and stable GDP growth which took its GDP per capita from $746 to $7,784. In 1994, China’s GDP/capita was in line with Sudan and only 15% of Brazil’s. By 1994, China’s GDP/capita reached 65% of Brazil’s. By 2018, China had surpassed Brazil.

By the turn of the century, China’s coastal regions which dominate economic activity had already reached the transformation point when consumption and demand for infrastructure and housing result in a surge of demand for commodities. This transformation point typically occurs  around when GDP/capita surpasses $2,000, which happened for Brazil in 1968 and in Korea in 1973. In 2005 China’s overall GDP/capita reached $2,000 and the commodity super-cycle was well under way. (All GDP/capita figures cited are from the World Bank database and based on 2015 constant dollars.)

Moreover, China was not the only significant country to enter this commodity-intensive phase of growth during the 2000s. The chart below shows the list of new entrants to the $2,000/capita club since the late 1960s. During the 2000s, three large EM countries, Indonesia, the Philippines and Egypt,  also broke the barrier. These three countries added fuel to the commodity boom created by China’s hyper-growth and infrastructure buildout, generating the commodity “supercycle.”

The historical link between rising commodity prices, a falling dollar and the incorporation of large amounts of new consumers into the world economy can be seen in the following three charts which cover the 1970-2020 period.. The first chart shows the rolling three-year average of the total annual increase in the population of global citizens with an annual income above $2,000. The second chart shows the  increase in commodity prices relative to the S&P 500; and the third chart shows the evolution of the nominal effective U.S. dollar. The connection between the three charts is clear: every period of rapid growth in new developing world consumers coincides with both rising commodity prices and a weaker USD. Not surprisingly, every bull market in EM stocks (1969-1975, 1987-92, 2002-2010) also follows this pattern.

 

The bull case for emerging markets investors today is that we are on the verge of entering a new cycle as five more countries pass the $2,000/capita barrier.  Already this year, Kenya and Ghana will reach this level. These two countries in themselves are not that significant but they point to the importance of Africa for the future. Then in 2021 India (pop. 1.4 billion) reaches the benchmark, followed by Bangladesh (pop. 170 million) in 2022. The following chart shows the evolution of the total global population with per capita GDP above $2,000 and the annual increases for the past 50 years and the next five years. The potential significance of India and Bangladesh are clear.

India will likely have an  impact on a different set of commodities  than China had. India is unlikely to achieve the pace of infrastructure growth that China had, and has significant iron ore resources. This means the impact on iron ore and other building materials will not be as great. On the other hand, India imports most of its oil and will have an increasing impact on the oil markets. India also faces great urgency to electrify the country and to do this with clean energy. This points to growing demand for copper , cobalt and silver, three markets that already appear to be undersupplied in coming years.

If you Like Emerging Markets, Buy Mining Stocks

Emerging market assets have always experienced good performance during times when commodity prices are rising. These periods are characterized by strong economic performance of the  global economy relative to the that of the United states and they are normally accompanied by a weak U.S. dollar. This combination of relatively strong growth and a weak dollar and the stimulative effect of higher commodity prices on commodity-dependent economies typically underpins bullish stock markets in EM.

The persistent relationship between commodities and emerging market stocks is illustrated in the chart below which tracks the prices of copper (black), EM (red) and the copper mining giant Freeport-McMoRan (blue).  (Copper is used as a surrogate for economically sensitive commodities). The chart shows that the prices of these three assets are directionally linked. Arguably, copper is a leveraged play on emerging markets and copper mining stocks provide further leverage on copper itself. This illustrates clearly the cyclical nature and economic sensitivity of emerging markets. It also raises an interesting and perhaps disturbing question for emerging market portfolio managers: why not obtain your general exposure to EM by simply timing the cycle and piling into a few mining stocks?

The viability of this strategy is shown in the next two charts. The first chart shows the performance of emerging market stocks (VEIEX) and of several of the most prominent mining stocks (Vale, Freeport-McMoRan, Vale, SQM and Southern Copper). These mining stocks all dramatically outperformed during the four cycles under consideration (2000-2008, 2009-2012, 2016-2018, and 2020-). Using a very simple 200 day moving average to trigger buys and sells, an investor could have enjoyed most of the upside and very little downside. The investor could have either shifted into cash or stayed invested by owning the EM index  whenever the copper price moved below the 200-day moving average.  The entry point this year would have been the first week of June. As the second chart shows, since that time the mining stocks have ramped up and left the EM index behind. This outperformance has occurred even though tech stocks in Asia have become much more important in recent years. Moreover, the performance is even much better compared to the EM ex-China index or a commodity-heavy index like Latin America.

 

Historically, reflation trades trend for long periods. If this one gets traction during the next six months, this trade may be only beginning.

Global Macro Outlook for Emerging Markets

Emerging market economies and assets are sensitive to global U.S. dollar liquidity, the global economic cycle and the fluctuations of investor appetite for risk. The past decade has been one of relative strength for the U.S. economy in an environment of declining global growth. Relatively high returns on capital in the U.S. on both risk-free assets and stocks have sucked in capital from around the world and caused a prolonged cycle of appreciation of the U.S. dollar. These circumstances have been negative for emerging market asset prices and caused a decade of poor performance for stocks. Periodically, it behooves us to evaluate market conditions to ascertain whether circumstances are changing, and we do this by following a simple framework which considers:  Global U.S. dollar liquidity; currency trends; commodity prices; and risk aversion.

Global U.S. Dollar Liquidity

The chart below shows a measure of global U.S. dollar liquidity based on the evolution of  the combined values of (1) global central bank dollar reserves and (2) the U.S. M2 monetary base, data provided weekly by the U.S. Fed. The second chart shows separately global central bank reserves.  We can see from these charts the extraordinary nature of the times we are in.  The unprecedented increase in USD liquidity has been driven exclusively by massive money printing by the Federal Reserve, and this liquidity is finding its way into markets through fiscal spending and mandatory lending programs. This is in sharp contrast to the 2008-2009 (GFC) crisis when most of the increase in global dollar liquidity was caused by China’s infrastructure stimulus, which boosted commodity prices and underpinned international trade. In the current situation, international reserves have seen only a slight increase, but only because of some $700 billion in emergency swap lines provided to U.S. allies by the U.S. Fed.

 The U.S Dollar Cycle

The Fed’s unprecedented interventions made in concert with Treasury,  as well as gargantuan fiscal deficits, steep increases in U.S. government debt and the prospects of a sustained period of high fiscal deficits underpinned by financial repression (forced lending and negative real interest rates) may be unsettling the U.S. dollar. Debt levels in the U.S. are rising precipitously at a time when, for the first time in a decade, interest rates in the U.S. are no longer higher than in Japan or Europe and may no longer attract foreign capital.  Interestingly, the spread in favor of Chinese government bonds vs. U.S treasuries has been rising and is now at near record levels. The charts below show the DXY index, which measures the evolution of the U.S dollar primarily vs. the euro and the yen, and also the MSCI Emerging Markets Currency Index, which measures the value of EM currencies relative to the USD. The DXY has fallen from its March high of 103.5 to 95, breaking through the 50-day, 200-day and 18 month moving averages. This has happened concurrently with a sharp rise in the price of gold, which is further evidence that the confidence in the USD may be breaking. Nevertheless, for emerging market currencies, the breakdown of the USD is much less pronounced. Still, the recent weakness of the USD is certainly heartening for EM investors.

Commodity Prices

Commodity prices reflect both the value of the USD and global economic activity. At the same time, in recent decades they have been a key factor in determining global liquidity because major commodity producers typically sharply increase dollar reserves when prices rise. Rising commodity prices lead to significant increases in both global liquidity and domestic liquidity for many emerging markets, and they are generally necessary for asset appreciation throughout EM. The chart below, from Yardeni.com, shows the Commodity Research Bureau (CRB) Industrials Index, which historically has been highly correlated to emerging market asset prices.  We also show the chart for the spot price of copper, which has rallied strongly over the past two months. We can see from these charts – particularly the CRB Metals and copper – that industrial metals are on the rise. The likely explanation is the current surge in infrastructure spending by the Chinese government in a mini-version of the great 2008-2009 stimulus. These are bullish trends which further should improve investor appetite for EM assets.

 

Risk Aversion

Emerging market assets are considered high-risk investments that require a large risk premium.  In times of market turbulence, these premiums tend to expand dramatically. Emerging market premiums for both stocks and bonds are closely linked in their trading patterns to U.S. high yield bonds. The chart below, from Yardeni.com, shows the spread between U.S. Treasuries and U.S. high yield bonds. This is a very good measure of risk aversion, which serves for EM. We can see that these spreads have come down steadily since March. They remain at relatively high levels, but mainly because Treasury yields have collapsed. The question that investors have to ask themselves is whether market prices reflect reality at a time of unprecedented intervention by monetary authorities.

Conclusion

Though it may be early to call for the beginning of a new cycle of strong performance for emerging market stocks,  several signs are supportive of this thesis.  The recent weakness of the USD and the growing challenges for the U.S. economy may point to an extended period of  relative strength for emerging markets. Further USD weakness and commodity strength would support increasing exposure to EM assets.

Batten Down the Hatches in Emerging Markets

The environment for emerging market stocks is poor and likely to get worst. Investors should recognize that the current storm may last a considerable amount of time and that it  inflict severe damage.

At the start of this year, there was, briefly, an illusion of blue skies ahead for investing in emerging markets. Global growth was expected to improve and surpass the United States. In emerging markets, growth prospects looked good in China, and recoveries in Brazil and Turkey, the two serious laggards of recent years, appeared to be firm. Commodity prices also were rising and the USD was slipping. All of this was setting the stage for capital inflows into emerging market stocks and a period of outperformance.

Unfortunately, the positive scenario suddenly unraveled when the coronavirus hit China and put a sudden stop to Chinese growth.

Today, the relevant indicators all point to sustained difficult conditions for emerging markets.

The US dollar is once again appreciating, as risk aversion around the world has caused capital to flee to safe assets like the dollar, the yen, the Swiss franc and gold. This has been particularly acute in emerging markets, with many countries seeing their currencies plummet. The MSCI Emerging Market Currency Index, which shows the value of all the currencies in this stock index relative to the dollar, has traded down to record lows, as shown in the chart below. Latin American currencies are in free-fall. This extends a trend started in 2012 and has happened in spite of massive intervention by central banks and large swap lines provided by the US Fed. Many emerging markets have participated in a massive yield-chasing “carry trade” over the past five years. We are now seeing this trade being unwound. At the same time, recent years have seen a marked increase in capital flight from domestic investors.

Risk aversion is on the rise. Emerging market stocks and bonds are “risk-on” assets that perform well when investors have increasing tolerance for risk and/or are induced by low expected returns in their domestic markets to seek higher returns abroad. This appetite for risk only persists if volatility is predictable, which had been the case until recent weeks.. We can measure risk appetite by the spreads that investors demand to invest in riskier assets. The spread between high-yield bonds  and US Treasuries, shown below in a chart rom Yardeni.com, is an accurate measure of this. We see that spreads have rocketed in recent weeks, despite the enormous liquidity being provided by the US Fed.

It is very difficult for emerging markets to perform well when commodity prices are weak. Falling commodity prices indicate both a  weak Chinese economy and deteriorating conditions for many of the emerging economies that rely on commodity exports. It also normally means declining US current account deficits and tight global liquidity. As the chart below shows, commodity prices have been taken a further notch down in a long-term declining trend started  in 2012. This week the CRB spot commodity index broke below the previous cycle low from 2016.

Low commodity prices and rising risk aversion are both contributing to very tight dollar liquidity and the persistent rise of the dollar. The chart below shows global liquidity as measured by central bank reserves held at the Fed plus US M2, and illustrates how tight these conditions have been in recent years. In recent months, the US Fed has recognized this, resuming quantitative easing and providing swap lines to foreign central banks.

Tight global liquidity, a rising dollar, falling commodity prices and heightened risk aversion translate into a very difficult environment for emerging economies. Just dealing with the coronavirus alone would already be an enormous challenge for the majority of emerging economies that don’t have the public health systems for preventive and active care and also don’t have the fiscal resources for alleviating economic losses. Unfortunately, many emerging economies will suffer additional challenges because the find themselves at record levels of indebtedness.

EM countries, as a whole, have increased debt levels dramatically in recent years. The chart below shows the increase in debt-to-GDP ratios for EM countries over the past five years.  This remarkable increase in debt levels across EM has occurred at a time of low growth and low investment. In the case of Latin America, debt increases have served only to finance interest and current payments and capital flight. Any increase in the ratio above 5% would be noteworthy. Only India, Russia and Thailand are below those levels. It may turn out that for Russia sanctions were a blessing in disguise.

External debt levels for many countries also are  at dangerous levels, as shown in the table below. Countries are considered to be overexposed to foreign credit when this ratio passes 30%. It should be noted that some of these ratios are understated, as debt issued offshore through subsidiairies is not included (eg., Petrobras issuing bonds in the Cayman Islands).

On the positive side, and looking forward to the reflation trade.

Not all is gloomy. Resilient EM countries will bounce back, particularly those that can implement financial repression to reduce debt levels. Asset prices in emerging markets are at very low levels. This is reflected in the value of most currencies, now well below fair value. We can see this in the chart below from Alpine Macro.

 

More importantly, the shift in the U.S. and Europe to “QE Infinity,” modern monetary theory and fiscal exuberance is likely to mark the beginning of a new inflationary cycle which will bring the dollar down and commodities up and trigger a new liquidity cycle supportive of EM assets.